The liquidity challenge…
In private markets, liquidity is the ultimate test and the main mechanism for returning capital to investors. According to Bain & Company, there are $3.2 trillion worth of unsold assets that are blocking returns of capital to investors due to a lack of IPOs and reduced M&A volumes. So, with this in mind, we want to share insights into our approach to generating liquidity in today’s venture capital market.
Opportunities beyond traditional M&A
In the UK venture capital market, the majority of exits will be through M&A, often to a US acquirer as this is the route to securing a greater premium and valuation. Our sale of Latent Logic to Waymo, an Alphabet Inc. company is an example in case. But European acquirers also play an important role in the M&A markets, and the acquisition of UltraSoc by Siemens is another example.
IPOs in the UK are treated with caution by many founders and investors are often nervous. It is a reality that the UK lacks the depth of investors and breadth of analysts to support enough of the rising stars of the UK’s technology sector that have been backed by venture capital, so more work is needed to connect the listed markets to the private capital markets.
There are bold new initiatives to address this issue. Earlier this year, we signed up to the Venture Capital Investment Compact together with over 100 venture capital investors, an industry initiative that was announced by the Chancellor to help unlock over £50 billion of capital by 2030 by enabling direct contribution (‘DC’) pension funds to access the potential high returns from supporting the UK science and technology sector. At present, only 0.5% of DC pension assets are invested in UK equities such as venture capital and growth equity.
While this initiative may unlock large amounts of capital, the effect may take several years to filter down, so other approaches are required.
While we expect M&A to continue to be the most common route to successful exits in the portfolio, we seek to generate liquidity through other mechanisms as well.
Secondary market transactions have emerged in venture capital backed companies with early investors able, on occasion, to generate partial exits of their investments. We have recently closed two transactions with the sale of half of our early investments in Red Sift, when the company raised an over-subscribed Series B round, and sold part of another holding to a strategic investor in a business seeking to increase their shareholding. In both cases, the shares were sold at or above the last round valuation and achieved returns of 9x & 10x for early investors. These transactions allow us to balance the certainty of liquidity with the potential upside of future returns.
Building on this is the opportunity to sell to private equity or private equity backed companies seeking to expand through acquisitions. While this may not be a route to maximising value, it can offer an exit route for an underperforming company by being consolidated. Our recent exit in Artfinder is an example, where the alternative would likely have been a liquidation.
Another route is via a management buyout with private equity. In traditional private equity, the majority of exits are achieved via a sale to other private equity buyers and businesses are handed over between funds each with a thesis for adding value to the investment before selling it to the next. This is not so for venture capital, which has traditionally seen M&A as the route to maximizing value. However, with more private equity firms looking at emerging growth opportunities as a source of deal flow, we have seen an increase in interest from investors seeking to build up stakes in technology businesses.
This dynamic also reflects the current market conditions, which have seen many venture capital backed businesses switch tack from a strategy of ‘growth focus’ to ‘profitability focus’. In turn, this has attracted the attention of private equity buyers who are more interested in businesses with positive EBITDA.
On occasion, some companies may position themselves to sell off part of their business as a way of returning value to shareholders. As a business grows, a division or international activity or part of the technology may be divested as a way of crystallising value and focusing the business on its core activity.
Ultimately, the preconditions to successful and high value exits remain largely unchanged with buyers seeking revenue growth, profit, product market fit, success in international markets, a stable customer base, strong management teams, defensible business models and good governance. Our role as an investor is to help founders build ‘good’ businesses, in the widest sense of the word, that are sustainable and attractive for the long term.
The technology premium
In technology there are also exceptions. Some companies are acquired early for their technology and intellectual property. Our investment in the Oxford University spin-out Latent Logic was an example, where the company had barely launched before it was acquired for its technology and to ensure it would not be accessible to Waymo’s competitors such as Tesla or Uber. This rapid exit, barely 18 months after the seed funding round, generated an attractive return for investors and its founders.
Portfolio companies are also active in M&A
The desire for liquidity in private markets also creates an opportunity for our portfolio companies. A number of companies are pursuing an active strategy of growth through acquisitions. Scan.com, Hometree and HelloSelf are three of the companies in the portfolio that have acquired other businesses to expand their market share and accelerate their business growth. These companies have been able to acquire other companies and take advantage of the favourable valuations and need for liquidity in the current market.